WOTC and EZEC: Tax Court draws a clear line for PEOs

The U.S. Tax Court recently delivered a decision that tax professionals should not overlook, especially those working with clients using professional employer organizations (PEOs). The court confirmed that only the common law employer, not a statutory employer or agent, can claim the work opportunity tax credit (WOTC) or the empowerment zone employment credit (EZEC).

This ruling settles a long-standing gray area and reinforces a traditional principle in tax law: control determines eligibility.

What are WOTC and EZEC?

Both credits are designed to encourage hiring in specific circumstances. The work opportunity tax credit provides a benefit to employers who hire individuals from targeted groups, such as certain veterans, long-term unemployment recipients and individuals with disabilities.

The empowerment zone employment credit applies to wages paid to employees who live and work in designated economically distressed areas. In both cases, Congress intended these credits to reward employers who create job opportunities in underserved populations and communities.

The case behind the decision

The case involved a PEO that handled payroll and employment-related administrative services for its clients. The PEO paid wages and claimed both WOTC and EZEC for employees working at client sites.

The IRS disallowed the credits. The PEO challenged the decision, arguing it qualified as a statutory employer under §3401(d)(1) because it controlled wage payments. The Tax Court disagreed.

Common law employer controls the outcome

In this case, since the statutes for WOTC and EZEC do not define “employer,” the court turned to common law principles. Under those rules, the employer is the party with the right to direct and control the details of the employee’s work. In this case, the PEO’s clients, often called worksite employers, supervised employees and controlled their day-to-day activities. That made them the common law employers.

The court emphasized that simply paying wages is not enough. The entity must also control how the work is performed.

Why statutory employer status is not enough 

The PEO argued that its status as a statutory employer or agent should allow it to claim the credits. The court rejected this position. Even though §3504 allows an agent to perform certain employer functions, such as withholding and paying taxes, it does not transfer the right to claim income tax credits. 

The court also dismissed arguments related to leased employee rules, reinforcing that these provisions do not override the common law employer standard for credits.

Congressional intent matters

The decision rests heavily on legislative intent. Congress created these credits to benefit employers who actually provide jobs to disadvantaged individuals or operate in distressed areas. 

A PEO, while essential for administrative support, does not create those job opportunities. The   client business does. As the court noted, a statutory employer that merely pays wages is not the intended beneficiary of these credits. 

Practical implications for tax professionals

This decision has immediate consequences for practitioners advising business clients. 

1. Review any prior or current credit claims involving PEO arrangements. If the PEO claimed WOTC or EZEC, those claims may be vulnerable on examination.
2. Clarify roles in PEO relationships. Many clients assume the entity issuing payroll automatically qualifies for employment credits. That is no longer a safe assumption.
3. Ensure proper documentation. The common law employer should maintain records supporting eligibility, including hiring certifications and proof of employee qualifications.

Finally, coordinate with PEO providers. Clear communication can prevent duplicate or improper claims and reduce audit risk. 

A return to fundamentals

This case is a reminder that long-standing common law principles still carry weight in modern tax administration. When it comes to employment credits, substance prevails over form. For tax professionals, the takeaway is straightforward: follow the control. If a client directs the work, supervises employees and bears the economic benefit of their services, that client is entitled to claim the credit.

Anything else is likely to fall short under scrutiny.